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					                                                  Observation                                    TD Economics

                                                  January 18, 2011

            HIGHLIGHTS                                 OUTSIDE	OF	MORTGAGES,	
                                              U.S.	CREDIT	SHOWING	BROAD	IMPROVEMENT
•	 Underlying	the	improvement	in	              The U.S. economic recovery has picked up steam over the last several months.
   economic	 indicators	 over	 the	
                                           The recent momentum in economic indicators, in combination with another round
   last	 several	 months	 has	 been	
                                           of fiscal stimulus, has led many forecasters – ourselves included – to upgrade the
   growing	signs	that	the	econo-
   my	is	also	seeing	a	recovery	in	
                                           outlook for real GDP growth over the next year.
   credit conditions.                          In a recovery punctuated by a credit crisis, unleashing economic potential will
•	 The	mortgage	market	continues	          require an improvement in credit growth. While the credit crisis began in the U.S.
   to	 act	 as	 the	 major	 constraint	    housing market, the credit freeze that took place in its aftermath affected all sectors
   on	growth,	but	outside	of	mort-         of the economy. In combination with broad losses in wealth, the increased cost of
   gages,	credit	availability,	credit	     credit and reduced availability for businesses and households contributed to the
   quality,	 and	 credit	 growth	 all	     depth and severity of the economic recession and the insufficient pace of recovery.
   appear	to	have	turned	a	corner.             However, as we move further away from the financial crisis, there are growing
•	 Commercial	banks’	willingness	          signs that credit markets are on the mend. While residential and commercial real
   to	 lend	 to	 households	 and	          mortgage lending con-
   businesses	 has	 moved	 from	           tinues to be constrained,                        BANKS	TIGHTENING	C&I*	
   tightening	to	easing.                                                                     LOANS	TO	BUSINESSES
                                           outside of mortgages,            Net-percentage
•	 Loan	 delinquencies	 for	 con-          credit availability, cred- 100                  Tightening
   sumer	 loans	 and	 commercial	          it quality, and credit 80
   and	industrial	loans	fell	consis-       growth are all showing 60                         Large Firms
   tently	through	2010.
                                           broad improvement.                                Small Firms

•	 Led	 by	 gains	 in	 non-revolv-         This trend bears watch-

   ing	 loans,	 consumer	 credit	          ing. As the minutes of 20
   growth,	which	represents	18%	
                                           the Federal Open Mar-         0
   of	 total	 household	 liabilities,	
                                           ket Committee (FOMC)
   has	 turned	 positive	 in	 recent	                                  -20
   months.	Correcting	for	charge-          meeting in December                               Easing

   offs,	consumer	credit	growth	is	        noted: “an acceleration -40
                                                                          1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
   accelerating.                           [in economic growth]
                                                                          *Commercial and industrial
•	 Faster	credit	expansion	means	          would likely be accom-         Source: Federal Reserve Senior Loan Officer Survey

   more	 money	 creation	 and	 re-         panied by significantly
   duced	risk	of	deflation.	               more rapid growth in bank lending and in monetary aggregates.” Given the type of
•	 While	the	recovery	in	credit	is	        recession and recovery we have experienced, an increase in credit may even lead
   still	in	its	early	stages,	a	further	   the move to higher economic growth.
   acceleration	 of	 credit	 growth	           What is more, the current weakness in real estate is less a matter of continued
   could	signal	a	move	to	a	much	          deterioration of mortgage quality, and more a legacy of past credit excesses. Reduc-
   stronger	 pace	 of	 economic	           ing uncertainty about the value of real estate assets and the eventual losses faced
   growth	than	currently	expected	         by lenders will depend on the pace of growth in the broader economy. Should the
   by	markets	or	forecasters.              improved pace of credit growth outside of real-estate markets accelerate, it could
                                           signal a move to a much stronger economic growth trajectory.
James Marple                               Credit	availability	is	improving	
 Senior Economist                              First on the list of encouraging signs is that the credit freeze is thawing and
 416-982-2557                              becoming more available. A key source of information with respect to the availabil-                       ity of credit is the Senior Loan Officer Survey conducted quarterly by the Federal
                                                                             Observation                                 TD Economics
                                                                             January 18, 2011                                                   2

                                                                                   even before the overall delinquency rate began showing im-
               WILLINGNESS	TO	LEND	TO	CONSUMERS                                    provement, there was a growing divergence in credit quality
           Net percent                                                             amongst different loan types. In particular, loans secured by
                                                                                   real estate have seen delinquency rates remain high, while
                                     More willing                                  unsecured loans to consumers and businesses have been on a
                                                                                   steady downward trend since 2009. The delinquency rate on
                                                                                   consumer loans, including credit cards, peaked in the second
                                                                                   quarter of 2009 at 4.9% and as of the third quarter of 2010
                                                                                   had fallen to 4.1%. Similarly, after peaking at 4.4% in the
                                      Less willing                                 fourth quarter of 2009, the delinquency rate on commercial
                                                                                   and industrial loans reached 3.3%.
                                                                                       The improvement in credit quality is important because
       1980          1985   1990       1995      2000       2005      2010
                                                                                   it could mark the beginning of a virtuous cycle where bet-
       Source: Federal Reserve Senior Loan Officer Survey, Haver Analytics
                                                                                   ter credit quality leads to more credit growth and improved
                                                                                   economic growth, which in turn feeds back into greater
                                                                                   credit quality.
Reserve. The most recent survey for the fourth quarter of
2010 was conducted in October and revealed that outside                            Consumer	credit	growth	is	accelerating
of residential mortgages, willingness to lend to consumers                             While understandably much of the focus over the reces-
and businesses continues to move in the right direction. On                        sion has been on the decline in mortgage credit, unsecured
net, commercial banks are easing standards on consumer                             consumer credit is an important component of household
credit cards and other loans, as well as on commercial and                         borrowing, representing close to 18% of total household
industrial loans for both small and large firms. As shown in                       liabilities. After decades of gains in consumer credit – fu-
the chart above, willingness to lend to consumers is at its                        eled by strong growth in credit card debt – consumer credit
highest level in over five years.                                                  plunged during the recession. From its peak, total consumer
Delinquency	rates	are	falling	                                                     credit fell by 7.3%, led by a 17.2% decline in revolving credit
                                                                                   (credit cards), and a 1.3% decline in non-revolving credit.
    The trends taking place in credit standards are also mir-
                                                                                       The change in consumer credit outstanding reflects both
rored in credit quality. Delinquency rates saw a meteoric
                                                                                   the write-down of non-performing loans as well as the
rise for nearly all types of debt over the recession. The total
                                                                                   change in credit due to consumer behavior – households
commercial bank delinquency rate for all loans and leases
                                                                                   taking on less debt or paying down debt. The main reason
peaked in the first quarter of 2010 and after remaining steady
                                                                                   for the decline in consumer credit over the recession was due
in the second quarter, fell in the third quarter. Nonetheless,

               COMMERCIAL	BANK	DELINQUENCY	RATES                                                 COMMERCIAL	BANK	CHARGE-OFF	RATES
           Percent                                                                         Percent
  12                                                                                  8

                            Real Estate Loans                                         7                     Real Estate Loans
                            Consumer Loans                                            6                    Consumer Loans
   8                        Commercial & Industrial Loans                                                  Commercial & Industrial Loans

   6                                                                                  4


   0                                                                                  0
    1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011                            1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

       Source: Federal Reserve                                                            Source: Federal Reserve
                                                                               Observation                                TD Economics
                                                                               January 18, 2011                                                    3

                            CONSUMER	CREDIT                                                                    CONSUMER	CREDIT
          Year-over-year % change                                                             Annualized quarter-over-quarter percent change
   20                                                                                   30


                                                                                                                    Revolving	Credit	
                        Consumer Credit Adjusted for Charge Offs*                       -10
   -5                                                                                                            Non-revolving	Credit
                        Consumer Credit
  -10                                                                                   -20
     1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010                     1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
         Source: Federal Reserve Board. *Calculation by TD Economics                      Source: Federal Reserve

to the former – a large increase in the charge-off rate. While                       basis, revolving consumer credit was slightly negative in
data on charge-offs for the entire economy is not available,                         early 2010 – a new phenomenon for credit cards – while
data is available for commercial banks, which represent just                         non-revolving net credit issuance slowed, but did not actu-
under half of total consumer credit. Charge-offs on consumer                         ally contract.
credit rose to a peak of 6.7% in the second quarter of 2010,                             Importantly, over the last several months, there has been
led by credit cards, which rose to 10.9% – the highest level                         a considerable improvement in consumer credit growth.
for which data is available going back to 1985.                                      Even with the impact of charge-offs, total consumer credit
    As shown in the chart below, by removing the decline                             rose in both October and November – the first two consecu-
in consumer credit due to charge-offs, we get a picture of                           tive monthly gains since June and July of 2008. Moreover,
the change in credit issuance. While this is only an estimate                        the weakness in consumer credit growth is concentrated
without data for the non-commercial bank sector, given the                           within credit cards. Non-revolving credit has seen fairly
importance of commercial banks in consumer credit, it is                             strong growth, rising by an average of 5.1% (annualized)
likely a good representation of broader trends. Correcting                           over the past five months. This turn from negative to
for charge-offs shows that household deleveraging did                                positive growth is particularly important for a variable like
lead to a slowdown in credit issuance. On a year-over-year                           consumer credit, which exhibits a lot of momentum. Look-
                                                                                     ing at the history of consumer credit, positive growth tends
                                                                                     to be followed by more positive growth (and vice versa).
                     CONSUMER	CREDIT	ADUSTED	                                        The fact that consumer credit growth has moved back into
                        FOR	CHARGE-OFFS*
                                                                                     positive territory is a good signal that it will continue to
         Year-over-year % change
  30                                                                                 grow in the months and quarters ahead.
  25                                                 Revolving Credit
                                                                                     More	credit	means	more	money
                                                     Non-revolving Credit
                                                                                        An increase in the pace of credit growth is significant
                                                                                     because it relates directly to the transmission of monetary
                                                                                     policy to the broader economy – lower interest rates only
   5                                                                                 stimulate growth if they result in an expansion of credit.
   0                                                                                 But, it is also important because of what it means for the
   -5                                                                                expansion of the money supply. With a fractional reserve
  -10                                                                                banking system, money creation depends on the creation of
    1986         1990        1994      1998       2002      2006        2010         new loans, which result in new deposits, which in turn result
        *Estimate by TD Economics based on commercial bank charge-off                in new loans – a process called the multiplier effect. So,
        rate. Source: Federal Reserve, TD Economics
                                                                                     the fact that credit growth appears to be expanding should
                                                                                  Observation                                   TD Economics
                                                                                  January 18, 2011                                                                4

                            	MONEY	SUPPLY                                                             RESIDENTIAL	MORTGAGE	DELINQUENCIES
         Year-over-year % change                                                                Percent of total loans
  20.0                                                                                     6

  17.5                                                                M2                                                        30 days past due
                                                                                           5                                    60 days past due
  15.0                                                                M1
                                                                                                                                90+ days past due
  12.5                                                                                     4

   7.5                                                                                     3


   0.0                                                                                     1

                                                                                            1980     1984     1988       1992     1996    2000      2004   2008
        2006        2007           2008       2009             2010        2011
        Source: Federal Reserve, Bureau of Economic Analysis                                   Source: Mortgage Banker's Association, Moody's

also show up in a faster pace of money supply growth.                                   Problems	 in	 mortgage	 market	 reflect	 legacy	 of	 past	
Looking at the aggregate money supply data – both M1,                                   bad	loans
which includes just currency and checking deposits, and                                     Perhaps the only mitigating factor in an otherwise good
M2, which also includes saving and time deposits – this is                              news story is the lack of traction within real estate secured
exactly what we see. On a year-over-year basis, weekly data                             lending. However, while the delinquency rate on residential
for M2 shows a growth rate of 4.0%, a steady acceleration                               and commercial mortgages has remained high, this does
from its trough (at 1.0%) in March.                                                     not mean that there has not been an improvement in the
    Given fears about deflation, the nascent rise in money                              mortgage market. Indeed, for residential mortgages, the
supply growth is an important development. Inflation is                                 percent of mortgages entering delinquency (that is, falling
essentially a monetary phenomenon – create enough (ag-                                  behind 30 days on their payments) also peaked in mid-
gregate) money and prices will rise. While the significant                              2009, as did the 60+ delinquency rate. Consequently, there
amount of economic slack is likely to keep a lid on price                               is a much smaller pipeline for future seriously delinquent
pressures over the next year, the increase in money supply                              mortgages. The outstanding issue in residential mortgages
growth, which is only likely to accelerate further under the                            is the backlog of mortgages that are 90 days or more past
Federal Reserve’s asset purchase program, eases signifi-                                due on their payments, but have not made their way through
cantly the risk of a deflationary spiral.                                               the foreclosure process.
                                                                                            While data for commercial real estate is harder to come
                                                                                        by, what is available for commercial mortgage backed se-
                                                                                        curities, suggests the same phenomenon is also at play for
         Year-over-year % change                                                        non-residential mortgages. In both cases, problems moving
                                                                                        seriously delinquent mortgages through the foreclosure
                                                                                        pipeline and into liquidation are the main reasons for still
                                                                                        heightened delinquency rates. Until there is more progress
    5                                                                                   on resolving delinquent mortgages, secured lending is likely
    0                                                                                   to remain impaired. As we discuss in our report, Resolving
                                                                                        U.S. Housing Problem Essential To Avoiding Japan Expe-
                              Assets             Liabilities
                                                                                        rience, without a resolution in housing, improvement in
                                                                                        other sectors of the economy can only push the gas pedal
                                                                                        down so far. At the same time, the fact that credit quality
  -20                                                                                   is improving outside of mortgages illustrates that resolving
    1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
                                                                                        issues in housing and commercial real estate could lead to a
    Source: Federal Reserve Flow of Funds
                                                                                        much faster pace of credit expansion and economic growth.
                                                                  Observation                             TD Economics
                                                                  January 18, 2011                                                         5

Bottom	Line                                                                   With interest rates at record lows and pent-up demand
    The U.S. economic recovery is becoming more firmly                    still present, the further along that U.S. households move in
entrenched. As the economy moves further away from the                    terms of repairing their tattered balance sheets, the greater
financial crisis, the balance of risks in terms of economic               the potential for spending to rise. While the deleveraging
activity must also reflect the potential for growth to surprise           process is likely not yet complete and the U.S. saving rate
to the upside. Perhaps the best early signal that upside                  is likely to remain elevated, stronger income growth will
economic risks may be gaining prevalance is the condition                 allow consumer spending growth to match. Moreover, as
of credit markets. Given the importance of the supply and                 expectations improve, greater wealth creation prospects
demand of credit to the Great Recession and recovery, an                  will allow for upside to spending alongside further balance
improvment credit growth could be the best sign that the                  sheet repair. The improvement in credit conditions is still
economy has moved into a virtuous cycle based on higher                   in its early stages and the housing market is still rife with
expectations for future demand that lead to greater invest-               uncertainty, but there is certainly cause for optimism in the
ment and production today.                                                direction of changes over the last several months.

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